Investment Company Act of 1940: Summary, Rules & Exemptions

Instructor: Jon Hooks

Jon has taught Economics and Finance for 32 years. He holds a Ph.D., in Economics from Michigan State University, and is a CFA charter holder.

The Investment Company Act of 1940 was created through an act of Congress to require investment company registration and regulate the product offerings issued by investment companies in the public market. In this lesson we discuss the purpose, background, and scope of the Investment Company Act

Origin of the Act

The U.S. mutual fund industry dates back to 1893 for closed-end mutual funds and 1924 for the more popular open-end funds. Since that first open-end fund, called Massachusetts Investors' Trust, the industry has grown to nearly 10,000 U.S. funds today.

Through private investing and company sponsored retirement plans, most Americans have some exposure to mutual funds. They went largely unregulated until Congress passed the Investment Company Act of 1940 (the Act), which mandates that investment companies are registered with the SEC. It also regulates products offered by investment companies when issued to the public.

Scope of the Act

The Act specifically spells out what kind of activities investment companies could undertake and gives standards for the industry. It clearly defines the responsibilities and requirements of investment companies as well as the requirements for publicly traded investment product offerings.

The Act's purpose is to mitigate conditions that adversely affect the national public interest and the interest of investors. Specifically, the Act regulates conflicts of interest in investment companies and securities exchanges. It seeks to protect the public primarily by legally requiring disclosure of material details about each company.

The Act requires investment companies to register with the Securities and Exchange Commission. And while it does not dictate investments, the Act does limit the use of leverage (borrowed funds) of open-end mutual funds and requires a cash buffer for redemptions.

Each investment company must have a board of directors, and 75% of those board members must be independent or unaffiliated with the fund's activities. The Act requires investment companies to publicly disclose information about their own financial health, including quarterly reports to investors.

Defining an Investment Company

Investment companies are corporations, partnerships or limited liability companies that sell market funds on a public basis. The main business of an investment company is to hold and manage securities for investment purposes, but they typically offer investors a variety of funds and investment services, which include portfolio management, record keeping, custodial, legal, accounting and tax management services all for an annual operating fee.

The investment company pools money from individual investors, professionally manages the money, and the investors themselves share any profits and losses incurred by the company according to each investor's interest in it.

Investment companies are categorized into three types:

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